The sharp shift in trade policy-- and the execution of policy more generally--is poised to erode U.S. (cyclical) growth exceptionalism quickly (see "Global Macro Update: Seismic Shift In U.S. Trade Policy Will Slow World Growth" published May 1). U.S. aggregate demand growth was already forecasted to slow down, given higher interest rates, curbs to immigration, and federal government cost-cutting initiatives. The spike in the tariff rate, heightened trade tensions, and policy uncertainty only further serve to accelerate that process (and to an even lower level).

The current U.S. policy-making environment is unorthodox with elements of transaction style, for which there is very little modern-day precedence. Economic forecasting is in unchartered territory, meaning forecasts are likely to have short shelf-life. At the moment, we anticipate U.S. real GDP growth will slow down to only 0.9% year over year by the fourth quarter of this year, in a baseline (central) scenario (table 1), and a recession in the pessimistic case (table 2). The line between quarterly domestic demand growth of less than 1% and what the NBER may consider a recession is very thin.

We currently peg the probability of a recession starting within the next 12 months at 35%.

Table 1

Our forecast exercise was completed before the release of advance first quarter GDP data by the Bureau of Economic Analysis on April 30,2025. First quarter numbers in Table 1 are reflective of our best guess on the running estimate for the quarter. The release of the advance estimate of first quarter GDP by the BEA doesn't materially impact our forecasts.

The U.S. tariff announcements of the first two weeks in April implied that average effective tariff rate on imported goods would be approximately 24% (compared to 2.3% in 2024), with a heavier skew on China.   Even after accounting for temporary suspensions and reversals, the current tariffs in place exceed our earlier expectations in both size and scope, lifting effective tariffs to levels not seen in nearly a century. While the dust is still settling on where the U.S. tariff rates ultimately settle, our central scenario now assumes 25% effective tariff rate on imports to the U.S. for the forecast horizon (up from 10% in our March forecast update), which can be split into the following main buckets:

• A 25% tariff on specific products deemed strategic by the administration, some of which have already been announced (autos with domestic import content exclusions, steel and aluminum) and some to be likely announced in the coming weeks (pharmaceuticals, semiconductors, refined copper, and processed lumber);
• A 10% tariff on all other imports (excluding those in the first bucket) from all countries excluding China; and
• A little above 100% average effective tariff on Chinese imports (after accounting for 145% "reciprocal plus fentanyl" tariff on two-thirds of imports and 20% "fentanyl only" tariff on the other one-third).

Core inflation is likely moving back up closer to 4%, twice the Fed's inflation target.   In March, core PCE price index was flat but that preceded the implementation of broad-based tariffs. Core inflation will inevitably rebound sharply in the coming months as tariffs begin to take effect. We forecast core CPI and core PCE inflation to rise to 4.0% and 3.6%, respectively, by year-end. We view this rise in prices as limited to a one-time bump in the first year, meaning we expect inflation will ease over the subsequent years towards the Fed's target rate of 2%.

Chart 1

Imports make up almost 11% of consumption. If that cost were to be passed on to households in full, the direct impact would boost consumer prices by more than 1.65% from our March forecast. Our baseline scenario, however, assumes a 50% pass-through (versus 75% suggested by empirical findings from Trump 1.0 era tariffs on China) to the final consumers (who are already cost fatigued unlike in 2018-2019) in the next 12 months, with the other half of increased tariff cost shared across the supply chain by suppliers, importers, wholesalers, and retailers.

Ability to pass through shocks to unit cost increases is bimodal, according to the Atlanta Fed's latest Business Inflation Expectations Survey. Small firms reported a lower ability to pass through unit cost increases, while medium and large firms reported a large distribution of ability to pass through unit cost increases.

A more favorable average tariff rates on countries other than China means opportunity for trade-shifting (to the likes of ASEAN countries) to temper potential import price shock. Still, despite a differential in tariff rates between ASEAN economies and China opening in favor of the former's export competitiveness, uncertainty surrounding U.S. trade policy likely still limits the immediate potential benefits that offshoring or re-routed trade from China would ordinarily offer, as seen during the first Trump administration.

The mix of price shock and uncertainty shock limits growth in the near term while stoking inflation.   The channels of impact have all the elements of:

• Dislocation of trade flows;
• Squeeze on consumer demand from the loss of purchasing power;
• Damage in business confidence and investment outlays; and
• Financial market turmoil and volatility.

Chart 2

Chart 3

Look beyond the noisy trade data to get the signal on how the economy is doing.   The first-quarter real GDP contraction of 0.3% (annualized) was significantly impacted by front-running of imports during the quarter. Net exports subtracted a massive 4.83 percentage points from real GDP. However, this surge now appears to be going into reverse (sharp reversal in container shipping data), and should boost second-quarter GDP growth.

Front-running of imports (and fear) aside, we like to look at final sales to domestic purchasers (core domestic demand) for the true underlying strength. Core domestic demand held up well in the first quarter, given 3% growth. Admittedly, it is a backward-looking view, but it still tells us that the economy was at a pretty resilient space heading into the headwinds of trade and business uncertainty.

Deterioration in sentiment data has been pronounced (recession territory) while the hard spending data are showing only incremental declines.   Sentiment and survey data (soft data) show trade-policy-induced uncertainty is a foremost concern. The movement in the soft data has been so pronounced (recession territory) that it is hard to ignore. The longer the process, the worse for business outlays, given the "wait and see" effect. The scope of uncertainty on tariffs may take several weeks to narrow, still.

Even as the hard spending data are showing only incremental declines for now, the consumer spending data should deteriorate further in the coming months as the tariff-led consumer price inflation weakens household real disposable income materially, leading to sequential growth in real consumer spending to average 1.3% the rest of the year. One would have to go back to 2012 for a similar weak consumer spending growth profile. (Back then also high levels of uncertainty gripped the economy with persistent talks about the Obamacare and ever-pending fiscal tightening, the upcoming presidential election outcome, and the financial market shock from Eurozone sovereign crisis).

DOGE-related cuts have also started to show up in the GDP data.  Federal government spending fell by 5.1% (spending among state and local governments continued to rise, albeit only 0.8%, which is on the soft side of last several quarters). As in our March forecast, we don't expect contribution to growth from the public sector this year and the next, a sharp reversal in one of the growth drivers of 2023 and 2024 (when it added 60 basis points to GDP growth on average).

In the medium term, the impact on real GDP depends on if the custom duties are recycled back into the economy, in the form of new tax relief measures.   We continue to assume it will be. It is looking more likely that the 2025 omnibus reconciliation bill will extend the 2017 tax cuts to households that are about to expire (neutral for our growth forecast as it is not adding to status quo). Current bills in the House and the Senate also point to a restoration of full expensing of R&D and equipment purchases for domestic production, which should be a net positive for growth in 2026 and beyond.

Our understanding is that tariff revenue cannot be formally included in the upcoming budget reconciliation, but it could be used to assuage the fears of Republican deficit hawks. Even after allowing for a decline in imports due to higher tariffs, the tariffs could still end up raising between $350 billion and $450 billion per year, or 1.0%-1.5% of GDP, over the next 10 years, according to various work-horse government budget models. We suspect that just as the last 100 days were about tariff policy, the next 100 days will be about tax policy.

Still, there is going to be permanent loss in our forecast horizon.   The economy ends up 0.6% smaller than in our March forecast when all is said and done in 2028.

Uncertainty around the policy outlook, weaker immigration growth, and DOGE cuts will weigh on payroll growth.   We expect payroll growth softening as the year progresses, with the pace of job gains falling under 100,000 a month in the second half of 2025 from 152,000 three-month average in March.

The public sector (federal, state, and local combined) will likely contribute zero to payroll employment in the second quarter and even lose net jobs for the second half of 2025, versus the three-month average of 33,000 per month and 17,000 per month in the fourth quarter 2024 and first quarter 2025, respectively. This is based on the hiring freeze in the federal government, announced cuts that have happened and are potentially coming, and a slowdown in hiring by state and local governments, which are constrained by balancing budgets and regardless won't offset federal government layoffs.

Chart 4

A slowdown in the public sector will have a knock-on effect for adjacent private-sector hiring--such as in the health care, education, and contract industries--perhaps more than in our baseline forecast. The sharp decline in immigration assumed in our forecast will add to supply-driven slowing in payroll growth.

In turn, we see the unemployment rate drifting up to 4.7% in the first half of 2026 from 4.2% currently.   This in part reflects that the reported 75,000 federal workers who have taken the option of severance will only be counted as unemployed after September if they remain so. The labor force participation rate will also decline because of the rising average age of the population, limiting the rise in unemployment rate (denominator effect). Growth slowdown earlier during this post-pandemic cycle was reflected in losses in job postings with little damage to the unemployment rate (see chart 6). We suspect that the upcoming growth slowdown will start to impact unemployment rate as it did in the past two pre-pandemic cycles.

Chart 5

Chart 6

In response to rising inflation, we anticipate the Fed will keep the federal funds rate steady at the current 4.25%-4.50% for most of 2025. We think the Fed will resume cutting in the fourth quarter as employment growth comes in consistently below 80,0000-100,000, a pace widely seen as "neutral" that keeps the long-term unemployment rate steady. Subsequent cuts in the first half of 2026 will then bring interest rates down to 2.88% in the third quarter of 2026, deemed accommodative relative to longer-run neutral of 3.1% nominal rate (considering the Fed's 2% credible inflation target).

Chart 7

Downside Scenario

Table 2

The unpredictability of policy-mix and uncertainty about the policy-response by various economic agents (very little historical precedence to work with) means lower degree of confidence on the stability of our baseline forecast.

There is a significant risk that the economy evolves in a more negative manner. In a more pessimistic scenario, we could see larger equity market decline, worse business investment outlays, and quicker trigger by businesses on laying off folks (unemployment starts rising sooner). The Fed starts cutting this summer (in the July meeting) and goes below neutral faster than in the baseline (by Q1 2026) to accommodate growth, despite uptick in inflation momentum due to tariffs and shortages.

Economic growth, in this downside scenario, ends up at 1.1% this year with two quarters of negative domestic demand growth beginning in Q2-Q3 and barely growing in the final quarter. Favorable changes to tax policy (such as advance expensing of investment) help restore growth starting late this year and builds on it next year, albeit not a sharp recovery.